Turkey will hold presidential and parliamentary elections on June 24th. These will prove crucial: they will mark the transition to an executive presidency, and will be held amid growing concerns following the recent sharp depreciation of the lira.

We believe that Recep Tayyip Erdogan, the incumbent, will win the election in the first round, and will get enough votes to form a coalition majority in parliament alongside the Nationalist Action Party (MHP), which is led by Devlet Bahceli.

The current bout of lira depreciation is driven, at least in part, by political instability ahead of the polls. We believe that a clear outcome in the first round of the elections will calm financial markets and stop the free fall of the currency.

In case this scenario does not materialise, Turkey could head into political chaos and experience a full-blown financial crisis.

On June 24th Turkey will hold presidential and parliamentary elections, well ahead of schedule (they were originally planned for November 2019). These polls will prove crucial; constitutional reforms that were adopted after a referendum in April will be implemented after these elections, shifting the country from a parliamentary to a presidential republic. Whatever their outcome, it is likely that these elections will prove controversial, as they will be held under an emergency rule that restricts freedom of assembly and speech.

Bringing the elections forward: another way to seize the day

Mr Erdogan's decision to bring forward the elections came as a relative surprise, but could be explained by three factors. First, the Turkish economy appears to be in relatively good shape; real GDP grew by 7.3% last year, and Mr Erdogan has resorted to various populist measures in recent months (for instance by giving generous handouts to pensioners on religious holidays) to make sure that Turks see tangible benefits of growth in order to boost his popularity. Yet Mr Erdogan also knows that the economic momentum may not last long, and probably not until November 2019, making the prospect of an early election attractive. Second, Mr Erdogan's popularity has risen in recent months, most notably after the nationalist surge that followed Turkey's military intervention in Afrin (a city in northern Syria). Third, the political opposition is fragmented; it has not been able to agree on a common candidate for the presidential election, and will therefore present a united front only in the parliamentary polls.

The most likely outcome: a first-round victory for Mr Erdogan

We believe that Mr Erdogan will be re-elected in the first round of the presidential election owing to his popularity, the positive coverage that he receives from state media, the fact that the emergency rule remains in place and the fragmentation of the opposition. We believe that Mr Erdogan will also manage to secure a coalition majority in parliament alongside the nationalist MHP party. Such a presidential and parliamentary victory will pave the way for the implementation of a one-man-rule system that will give (almost) full powers to Mr Erdogan until at least 2024, and possibly beyond.

Turkey has gone through financial turbulence relatively well in the past

However, the fundamentals of the Turkish economy appear solid. First, the fiscal position remains strong, as the country combines a small budget deficit (at a relatively modest 1.5% of GDP in 2017) with low public debt (which amounted to 28.3% of GDP at end-2017) owing to the government's fiscal discipline. Second, the banking sector is in relatively good shape; it is profitable, well capitalised, and the share of non-performing loans remains low (at only 2.8% at end-2017, according to the IMF). The recent lira depreciation will raise the local currency value of foreign-currency-denominated debt repayments for the private sector, increasing the risk of corporate defaults. However, the lira depreciation will also boost the competitivity of Turkish exporters, mitigating the impact of higher debt repayments. Third, the private sector remains dynamic, partly owing to the large size of the Turkish market (about 80m people), and has successfully weathered financial turbulence in the past.

The current bout of lira depreciation should end after the elections

For all these reasons the current bout of lira depreciation appears to have been driven by political volatility ahead of the elections (history shows that currencies are more volatile ahead of major political events such as elections), as well as Mr Erdogan's unorthodox statements regarding monetary policy and the adoption of fiscal policies that pointed to a loosening of fiscal discipline. We therefore believe that the lira will stop its free fall after the elections, and might even regain some of its value against the US dollar in the second half of the year. Yet this does not change our view that the lira will continue to depreciate gradually in the medium term.

Downside risks remain sizeable

There are downside risks to this optimistic scenario, however. The most important one is if Mr Erdogan fails to secure his re-election or, less importantly, to secure a majority in parliament. Such a situation could lead to political chaos and have a negative effect on foreign investors' sentiment. In turn, the lira would continue its sharp slide, increasing pressure on the banking sector and possibly leading the Central Bank of Turkey to re-impose capital controls and deplete its foreign-exchange reserves to defend its currency. Another downside risk would consist in a sharp tightening of global liquidity (severing the access to funds for Turkish banks and thereby raising borrowing costs), for instance if the Federal Reserve (the US central bank) was to raise interest rates quickly. A sharp rise in global oil prices (Turkey imports almost all of the oil and gas that it consumes), for instance as the result of heightened geopolitical tensions between Russia and the West or in the Middle East, would also weaken the currency and further widen the current-account deficit.